If all goes well with its February 28 filing with the Securities and Exchange Commission, Spotify will be the first firm to go public in the U.S. via a direct listing on a stock exchange. Simply put, this means that, rather than first selling a typical 10 percent to 30 percent of its shares outstanding to the general public (at a heavily discounted offering price), Spotify will immediately begin trading on the New York Stock Exchange. Up to $1 billion worth of shares will be supplied by existing shareholders of the firm and sold in the open market to new shareholders. This is precisely the way many firms in the UK go public, and it works rather well, allowing firms to raise capital later on favorable terms.
I sketch the lessons for Spotify’s direct listing based on the UK experience with direct listings, which have been taking place for several decades. I also explain a very general approach to valuing Spotify. The mechanics of this highly anticipated direct listing in the U.S. have already been written up in various media outlets. For example, my fellow contributor, Professor John Coffee of Columbia Law School, provides background on the subject while exploring the main legal issues here.
Who Can Pull Off a Direct Listing?
A direct listing is not for every firm. Prior to going public, private companies hit the road with their investment bankers to meet with large numbers of institutional investors around the country and the world. The meetings allow the firm to pitch its business model to the financial market participants who will own or trade its stock once it goes public. They are also an opportunity for investors to probe management so that they can decide for themselves what the company is worth.
In a traditional initial public offering in which firms also raise capital, these road shows provide the firm’s bankers with a good estimate of demand for the firm’s stock – who is willing to pay what price. This information, in turn, allows the bankers to determine the market clearing price for the firm’s stock as well as to price the offering. Since it is costly for institutional investors to produce information about the firm, they are unwilling to reveal their valuations for free. Bankers get institutional investors to play ball by giving them shares in the offering at a 20 percent or so discount to the market clearing price.
Even for well known firms like Spotify, the meet and greet part of the road show is still worthwhile. But they don’t need to pay institutional investors to reveal their private valuations, because they don’t need to raise any capital, and their valuations are already widely available to the investing public. For a few hundred well known large private firms like Spotify, it makes a lot of sense to do a direct listing. For the many thousands of very small and largely unknown private firms, a traditional IPO may be a better choice.
What Will Spotify Be Worth as a Public Firm?
It’s impossible to be sure, but the most recent valuation of a firm by private equity investors puts a floor under the market capitalization of the firm as it begins to trade publicly. In Spotify’s case, investors were valuing the firm at around $20 billion in late 2017. The cash flows supporting this valuation are robust sales growing from well under EUR 1 billion in 2013 to well over EUR 4 billion in 2017, combined with healthy profit margins.
Given what private equity investors were recently paying for Spotify, the firm should start trading publicly at around, or slightly above, $20 billion in market capitalization. That’s because having publicly traded shares improves stock liquidity and allows private equity investors to diversity their portfolios away from Spotify. Both of these considerations tend to lower the cost of capital and hence increase the company’s valuation.
What impact should we expect from fluctuations in the broader market? To well diversified investors, Spotify is probably riskier than the stock market as a whole. Therefore, the change in the value of Spotify will likely be greater – 1.5 times is a reasonable guess – than the change in the S&P 500 Index for the same period.
What Is to Be Gained by Waiting to Raise Capital Later?
The question isn’t what is to be gained but what is not to be given up. The answer is the opportunity to sell stock at a higher price. Firms doing a traditional IPO typically underprice by very roughly 20 percent the shares sold to investors in the offering as opposed to selling stock with almost no discount to the market price once the firm begins trading.
By contrast, when firms whose stock is already traded publicly raise capital, their underpricing is essentially negligible. It pays handsomely for firms to wait a bit to raise capital – this much is clear from the UK experience with direct listings followed by public equity offerings.
Will Spotify’s Direct Listing Really Be a First?
Yes and no. Many industry leaders have gone public even though they had no need to raise capital: Microsoft in 1986, Google in 2004, and Facebook in 2012, to give some famous examples. (They went public at least partly because the number of their shareholders was about to surpass the maximum permitted for private firms, owing to their issuance of stock-based compensation to their employees.) They clashed loudly and openly with Wall Street as they went public, but they eventually compromised by selling a small stake (typically, about 10 percent) in a quasi-traditional IPO (an auction in Google’s case).
Furthermore, a sizeable minority of firms going public each year are spinoffs from parent firms that are already public. In these spinoffs, the parent firm simply gives its own shareholders newly issued shares in a subsidiary that subsequently begins trading publicly as an independent firm. Critically, however, there are no shares sold in spinoff IPOs. Instead, shares are simply given away for free to shareholders who will own both the rump parent and the new subsidiary. Spinoffs provide a fairly good precedent for Spotify’s direct listing.
Will Market Volatility Dash Spotify’s Hopes?
Few investors remain unaware of the turmoil in financial markets that started in February 2018. Market downturns are usually bad news for firms going public, forcing them to either go public at depressed valuations or more often delay traditional IPOs by several years.
Direct listings, however, can save the day, judging by the UK experience. If firms are willing and able to separate the listing decision from the capital-raising decision, they can undertake a direct listing during adverse market conditions. Over the subsequent few months (or sometimes years, for smaller firms), a liquid market will likely develop in the firm’s stock.
Once much of the uncertainty about a firm’s value dissipates through active trading in its shares, the firm can then raise capital at approximately its market price. In fact, compared with firms that are still private, firms that went public via a direct listing will be able to raise capital more quickly when market conditions improve. This can be a competitive advantage for financing corporate investment in a newly growing economy. We observe precisely this two-stage IPO phenomenon in the UK.
Why Is This Time Different?
Spotify’s decision to go where no U.S. firm has gone before is the result of a confluence of factors. First and foremost, Spotify has some very good cards to play. It’s a leading firm in its industry. It doesn’t need new capital right away. The IPO market in the U.S. has been in the doldrums since 2000, leaving investment banks desperate for new corporate finance business. All of these factors strengthen Spotify’s hand.
Second, the current regulatory environment is nudging Spotify toward a direct listing. Jay Clayton, the new chairman of the SEC, has been pushing for deregulation and experimentation. Direct listings look promising, especially if they lower the cost of going public compared with staying private or selling to other firms.
Last but not least, Spotify is a Swedish firm whose managers are well aware of their options in going public – such as a direct listing in the UK. This puts some pressure on the U.S. exchanges, and the NYSE in particular, to accommodate an attractive new listing like Spotify with a direct listing rather than ceding ground to the Europeans. We should be delighted that Spotify’s approach to going public, like its business model, is pushing the boundaries with a direct listing.
This post comes to us from Professor Ambrus Kecskés at York University – Schulich School of Business. It is motivated by his pioneering study with François Derrien at HEC Paris, “The Initial Public Offerings of Listed Firms,” available here